Financial Statements Measure Wealth and Wealth Created

Learn to better understand financial statements and how to interpret and report on them. CC Photo via Ken Teegardin.

This is the first of a series of articles focused on financial accounting disclosures and how you, as a journalist, can interpret and report on them. The purpose: to help you use financial statements (and disclosures based on financial statements) to ask pertinent questions about businesses’ financial performances then, credibly assess managers’ responses to your questions.

The series presents lessons to help you read, comprehend and interpret financial statements while focusing on current financial statement issues.

Let’s start with a question: What do financial statements measure?

Surprisingly, this question is difficult to answer. Textbooks don’t answer it. At the start of each semester, I ask my upper-level undergraduate accounting students, mostly aspiring CPAs) this question, but they aren’t sure, nor are many managers and financial professionals.

Here is a succinct answer: An entity’s financial statements present information on the level of wealth an entity controls at a point in time and wealth created (or destroyed) by the entity over a period of time. Accountants report on wealth levels and wealth created because investors want to invest in companies generating wealth. Accountants also report on cash flows because investors recognize that cash flows help signal a company’s health.

Financial statements (introduced below) is the balance sheet (more formally termed the Statement of Financial Position) that measures and reports on an entity’s wealth level at a point in time. The income statement (more formally the Statement of Operations or Statement of Comprehensive Income) reports on wealth created or destroyed over a period of time. Since cash flow is important to the success of any entity, the financial statements include a Statement of Cash Flows.

For any business, wealth flow (the income statement) and cash flow (the statement of cash flows) need not occur during the same accounting period. For example, Boeing may receive cash from a customer this year (the current accounting period) as a deposit to build an airplane, then build and deliver the airplane next year (which is when it creates wealth for itself). The customer may then pay cash to Boeing for the purchase price, less the initial deposit, and will likely do so over for several years. Wealth flow disclosed on Boeing’s income statement will differ from cash flow disclosed in its statement of cash flows for the current year and future years.

Intuition behind balance sheets and income statements:

Figure 1 illustrates a balance sheet for ABC Corporation. Notice that the sheet lists and totals ABC’s assets. Total assets represent the wealth controlled by an entity at a point in time (as accountants measure asset values). Future articles will describe many different types of assets and discuss how they are measured.

Since an entity such as ABC is inanimate, its assets, representing the wealth controlled by ABC Corp., are claimed by (i.e. belong to) other entities or individuals who have loaned funds to ABC or invested in equity shares of ABC. That means that ABC’s assets are equal to its liabilities plus shareholders’ equity. In symbols, A = L + SE. This equation is an equality that always balances, thus the name balance sheet.Figure 2 illustrates an income statement for ABC Corp. It lists revenues and gains, which are wealth inflows during an accounting period (the year ending December 31, 2015). The income statement also lists expenses and losses, which are wealth outflows during ABC’s accounting period. The net wealth inflow or outflow is net income (also called net earnings) or net loss.

How could you use this knowledge as a reporter? What questions might it prompt?

Given that ABC Corp’s assets represent wealth controlled by ABC and net earnings represent wealth created during the year, you could form a ratio of net earnings ÷ total assets, which is one version of a popular ratio: Return on Assets or ROA (warning: different acceptable methods exist to calculate this ratio). ROA would help you assess whether a firm such as ABC can generate a high return (create wealth) from its assets (wealth level). To start generating questions as a reporter, this ratio could be:

Compared to ABC’s prior year performances to assess trends

Compared to ABC managements’ expectations to assess whether they met their goals

As an example, for the years 2014 and 2015, Southwest Airlines generated a return on assets of 5.8% and 10.2% while Delta Airlines generated 1.2% and 8.5%. Over the years, Southwest often generates a higher ROA than competitors: It seems better able to manage its assets (which are primarily airplanes) to generate higher returns (create more wealth with its assets) than many other U.S. airlines.

Next week we’ll discuss measurements of wealth. Most of the interesting controversies surrounding financial statements stem from disagreements about wealth measurement.